Optimal salary/dividend split for contractors for 2024/25

Welcome to another tax year, contractors!

Here, I'll outline the most tax-efficient salary and dividend levels split for the 2024/2025 tax year (6 April '24-thru-5 April '25).

First, I'll tackle the tax bands where income is drawn as salary.

Then, we'll look at dividend thresholds and the optimal split between the two.

Finally, we'll look at scenarios and strategies that optimise the various tax breaks on offer to limited company and PSC owners.

Moreover, how you can extract money from your company without paying through the nose for the privilege.

Income tax: salary

For 2024/25, the personal allowance remains the same as last year: £12,570. So, the first £12,570 you earn this year is tax-free.

If your salary is your only company director income, then any additional salary above £12,570 will incur tax at 20%.

Once your earnings breach the Higher tax band (£50,271), your salary up to the Additional rate will be taxed at 40%. 

For any income you earn above £125,140, the Additional rate, for the 2024/25 tax year, you'll pay tax at 45%.

There are other thresholds and tax issues of which I need to make you aware. But, for this illustration, I’ll try to keep it purposely simple.

Tax dividends, tax year 2024/25

The dividend allowance means that an individual's first £500 of dividends is tax-free, £500 less than last year. Over and above £500, the dividend income is taxed as follows:

Unused personal allowance

Any unused personal allowance—£12,570 for 2024-25—is tax-free. To see how that stacks up against other income, let's look at a simple example.

Imagine your only income was dividend income. £13,070 of this would be tax-free dividend income in 2024-25. This incorporates both your £12,570 personal allowance and the £500 annual dividend allowance.

Dividend tax thresholds

The basic rate tax band for 2024/25 is £12,571-to-£50,270. Any dividend (above unused Personal Allowance) falling in the basic rate tax band (from the £500 free allowance up to £50,270) is taxed at 8.75%

The Higher rate tax band for 2024/25 is £50,271-to-£125,140. Dividend falling in this band will incur charges of 33.75%

Additional rate dividends (above the Higher tax band of £125,140) will be taxed at 39.35%.

The marginal rates of tax can be even higher if you trigger other tipping points. These could be child benefit charges at £60k or the £100k personal allowance clawback threshold.

Optimal salary for one- and two-person payrolls

HMRC has withdrawn the employment allowance for one-person payrolls. This means one-person payroll's optimal salary is £9,096 per annum (£758 per month).

Where two or more people are on the payroll, e.g. husband and wife, their optimal salary is £12,570 per annum.

The optimal tax position, i.e. drawing dividends that take you up to but not exceeding the higher rate tax threshold, has changed little.

Where the taxpayer/contractor or their spouse receives other income, the optimal dividend should be reduced so that the aggregate income does not exceed the higher rate tax threshold of £50,270.

Optimal salary dividend split for contractors, 2024/25

The optimal position for the tax year 2024/25 is, therefore, as follows:

For one-person payrolls:	Annual Totals (tax year 2024-25)
Salary	£9,096
Dividend	£41,174
TOTAL:	£50,270

Two or more person payrolls:	Annual Totals (tax year 2024-25)
Salary	£12,570
Dividend	£37,700
TOTAL:	£50,270

Strategies for achieving the optimal balance

Many contractors choose to limit dividend income to avoid paying tax at the higher band (>£50,270 for 2024/25). 

Whilst restricting salary and dividends is the optimal tax strategy, it's not always possible.

How much you draw is a personal choice; striking a balance is key to a fulfilled lifestyle.

Consider your preference for tax efficiency versus the retained profits in your business.

Yes, you want to operate as tax-smart as possible. But don't live so frugally that you're skrimping to cover your day-to-day living expenses.

By the very fact that you're a limited company contractor, your earnings are such that your retained profits should exceed the above drawings level.

The main challenge that arises, then, is how to eventually—and efficiently—extract the retained profits from your company. Here are the main options to that end:

Spousal dividend distribution

Ensure dividend is distributed between spouses to fully utilise each spouse’s personal allowances and basic rate tax band. 

For a contractor whose spouse/civil partner receives little or no income, the problem is less acute. That's because each shareholder can draw up to £50,270, giving a total net drawing of £100,540 per annum.

If the contractor or their spouse/civil partner receives other income, reduce the optimal salary and dividend accordingly. Ensure that the aggregate income per taxpayer does not exceed £50,270; or, if higher drawings are necessary, avoid the various tipping points.

Closing the limited company

This option is most appropriate for contractors considering either retiring or returning to permanent employment.

Where possible, restrict drawings to the optimal salary and dividend level until the company can be closed. Thereupon, the retained profit can be distributed at 10% via Business Asset Disposal Relief (previously known as Entrepreneur Relief [up to 6 April 2020]).

If the net asset value to be distributed on closure is more than £25k, you'll need to close the company using members' voluntary liquidation. Only then will the capital distribution qualify for the 10% Business Asset Disposal Relief tax rate.

In essence, you retain excess profits in the company to shelter them from personal tax until you can extract them tax efficiently upon closure of the company. 

Targeted anti-avoidance rule (TAAR)

Do take care not to fall within the new anti-phoenixing targeted anti-avoidance rule (TAAR).

This rule claws back the benefit of Business Asset Disposal Relief relief. It triggers if the individual receiving the distribution continues in, or is involved with, the same or similar trade to that of the wound-up company. 

The catchment period is any time within two years from the distribution date.

n.b. The anti-avoidance will only apply if it is reasonable to assume that the main purpose, or one of the main purposes, of the winding up is the avoidance or reduction of a charge to Income Tax.

Property investment 

A common reason contractors extract retained profit from their PSC (personal service company) is to invest in property.

In particular, many contractors top up their income/pension pot with residential buy-to-let portfolios. 

One option is to buy property investment through the company, thereby avoiding the need to extract the funds from the company. 

Several lenders specialise in lending to limited companies to fund buy-to-let property investments.

True, the number of mortgage products is fewer than are available for personal ownership. But, sufficient lenders offer them to ensure competitive interest rates. 

Property ownership through a limited company also gets around some of the recent negative changes to the taxation of rental income. In particular, from 6 April 2017, the government began restricting interest relief on rental properties for higher-rate taxpayers.

Pension contributions 

Contractors can choose to fund their pension through their limited company. That's because employers can contribute up to £60k annually to their employees' personal pension scheme.

Furthermore, any unused pension allowance can be carried forward for up to three years. This allows a maximum potential single contribution of up to £240k (where the allowance was unused in the previous years).

Annual pension allowances are subject to certain restrictions, such as the "tapered annual allowance" and "lifetime allowance" rules. Unless you know them backwards, you should seek professional advice before making any pension contributions.

SIPPS/SSAS pension investments

Pensions have become more robust, powerful and flexible tools for investing in commercial property.

A SIPP gives you the flexibility to save and invest in anticipation of your retirement. Similar to a standard pension, it puts you in the driving seat of where and how you want to invest.

SSAS pensions allow a limited company to borrow from its own pension fund, up to a limit of 50% LTV at any time.

The SIPP's "defined contribution" would, in this instance, be the property investment, which is then administered through the company for the benefit of its directors and employees (where applicable).

Relaxation of the pension rules

You are no longer forced to buy an annuity. There's no longer a restriction on the amount of your pension fund that can be withdrawn as a lump sum after age 55. 

As such, funding a pension has become a more attractive prospect for many contractors.

You can, as a rule of thumb, treat employer pension contributions as tax-deductible company expenses. This directly reduces the company’s corporation tax liability. Plus, the contributions themselves aren't treated as taxable income or drawings.

Director's loan and Section 455

Not all contractors are moved to invest in a pension or property. Others can't restrict their drawings to the optimal salary level. In these instances, they could consider using directors' loans as alternatives to paying dividend.

Here's the scenario

If money drawn from the company exceeds the director's optimal dividend and net salary, they can treat the excess as a loan from the company. 

If the loan isn't repaid within nine months of the company’s accounting year-end date, the company must pay a corporation tax deposit at 33.75% of the overdrawn loan balance. This then falls under the Section 455 tax assessment.

The amount is equivalent to the tax that would have been payable if the director had taken the excess amount as a dividend. However, the advantage of paying tax under Section 455 compared with higher-rate income tax on a dividend is that it's repayable when and if the director's loan account is repaid.

One way a director's loan account can be repaid is via a contra account. The account balance is offset against the capital distribution payable to a director upon the closure of the company through members' voluntary liquidation.

How contra offset works

When a company is eventually closed by members' voluntary liquidation, the shareholders are entitled to receive the retained profits as a capital distribution. That capital distribution can be offset against the amount the director owes the company as reflected by the director’s loan account.

This then triggers a repayment of the Section 455 tax deposit. 

The shareholders will still have to pay tax on the capital distribution. However, assuming Business Asset Disposal Relief can be claimed, the rate of tax payable is only 10%.

Accordingly, using directors' loans allows a 33.75% liability to be reduced to just 10%, thereby saving 23.75%.

The advantage of using Section 455

The advantage, then, of Section 455 tax over dividend tax is that Section 455 tax is potentially refundable. Under the right circumstances, you can claim the tax back upon closure of the company. 

HMRC announced that it may yet introduce measures to tackle moneyboxing if it perceives this to be a problem. The risk that HMRC would view contractors using directors' loan accounts in this way could increase the longer closure is deferred.

Nevertheless, HMRC has historically been content to assess directors' loans as tax under Section 455.

Adult shareholders and Anti-Avoidance Rules

You could consider having more adult shareholders in the company. This would provide a tax advantage where the dividend is distributed to basic-rate taxpayers. That's because they only have to pay tax at 8.75% on dividend income.

However, there are risks to this strategy. HMRC can use settlement legislation to attack situations where dividend is distributed to a non-spouse simply to avoid paying higher-rate tax. 

This is particularly the case where:

• the dividend is circulated back to the contractor/taxpayer,
• it's used to settle the contractor's/taxpayer's personal liabilities, or 
• the taxpayer receives an economic benefit from the dividend paid to a non-spouse shareholder.

To protect against anti-avoidance rules, it helps if the shareholder has an active role in the company. Or if you can show they provided value to the company, e.g. they paid market value for their shares.

Given capital gains tax rules, it's more practical and tax efficient to demonstrate this if third-party shareholders invest capital in the company by subscribing for shares on the startup of your new company.

Reach out to a specialist contractor accountant

Whilst the advice is thorough and actionable if you're confident in your own abilities, it will still seem like a maze to some. You're not alone. Even I've had to run many of the facts, strategies and advice above through a specialist contractor accountant.

The main takeaway is the optimal 2024/25 salary v dividend split for limited company contractors. If that's all you glean from this article and want to leave the rest to your accountant, I get it.

You work too hard to risk inviting the wrath of HMRC through a taxation oversight. So, if there's any element you think applies to you but you're unsure, reach out. With the taxman, it's always better to be safe than sorry.

Thank you.